more hedge fund investors are going direct. should your institution?

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1 by A. Nicholas De Monico, CEO, Hedge Fund Strategies Group and Brett Lane, Managing Director, Hedge Fund Strategies Group, Commonfund more hedge fund investors are going direct. should your institution? direct, fund of funds or a combination: more options for more institutions INSIGHTONLINE spring/2014 1

2 he chart on this page illustrates T a trend that has been gathering momentum for the past five years: increasing direct investment in hedge funds and a moderate reduction in investment via hedge funds of funds. Both approaches grew rapidly in the 10 years from 1997 to 2007, just as both pulled back during the financial crisis. Post-crisis, growth resumed for direct investment, but remained flat to modestly lower for the funds of funds alternative. What happened? The reasons behind the divergent trend lines are subtle and complex there is no cut-and-dried answer, just as there is no single choice that is right for every institution. For some, direct investment may be the more appropriate option; for others, funds of funds are a better fit. As the chart below makes clear, there has been tremendous growth in hedge fund assets under management over the past 15-plus years, and much of the growth has been driven by institutional investors. Although hedge fund investing was not new, a number of institutional investors started allocating to hedge funds only in the recent past. At first, institutions treated hedge funds as almost a standalone allocation, segregated from mainstream equities and fixed income as well as more familiar alternatives, such as real estate, private capital and hard assets. Investors believed this would allow them to better evaluate hedge funds risk/return profile and accommodate liquidity needs. In this environment, a commingled product, like a fund of funds, provided immediate diversification as well as the comfort of knowing the provider had vetted the managers and would deliver all the associated portfolio management services. THINKING EVOLVES OVER TIME Time has passed and investor thinking has evolved. Institutional investors are no longer looking at hedge funds as a separate asset class (indeed, they never were a separate asset class, but rather a range of discrete investment strategies). The discussion now is about the role of hedge funds in the asset allocation policy: What s their place in our equity or fixed income allocation? Should we carve out a role in our thematic bucket, e.g., inflation, capital growth, or market volatility hedge bucket? In this context, direct investing may be a reasonable choice because it responds to the desire and ability to use hedge funds in a very precise and targeted manner. For example: NET INFLOWS TO HEDGE FUNDS Investment in hedge Assets Under Management $2,500 2,000 1,500 1, Dollars in Billions ($B) fund strategies, both direct and funds of funds, grew steadily until the financial crisis of Since then, growth has resumed for the Q/11 4Q/11 2Q/12 4Q/12 2Q/13 4Q/13 direct approach but has been flat to lower Hedge Funds Sources: Barclayhedge, Commonfund Funds of Funds for funds of funds. INSIGHTONLINE spring/2014 2

3 Direct investing may be a reasonable choice because it responds to the desire and ability to use hedge funds in a very precise and targeted manner. An institution seeking to enhance the risk/ return profile of its equity allocation may want to introduce a directional strategy perhaps a hedged equity, commodity trading advisor (CTA) or global macro manager and that level of precision may be achieved most effectively by going direct. Investment committees, as well as their consultants and intermediaries, are closely monitoring their fixed income allocation after a long decline in rates to historically low levels. Rates appear to have only one way to go; the question is when. In this environment, a long/short credit fund or a multi-strategy credit fund may offer the potential to hedge the rate risk. Direct investment is also a way to implement a thematic strategy. There is a case, for example, for targeting Asia based on favorable demographics, including a burgeoning middle class, stronger domestic markets and less dependence on exports. An institution could build an allocation with a long-only approach or may decide to hedge its exposure by incorporating regional hedge fund managers implementing a variety of hedge strategies. While the ability to use hedge funds in these precise ways may be the chief motivating factor behind the movement toward direct relationships, there are others (in addition to the basic rationale for hedge funds the potential for higher returns, portfolio diversification and risk management, especially in volatile environments). Flexibility goes hand-in-hand with precise targeting, as going direct gives investors the ability to determine the size of their commitment and shape the profile of the allocation. Another factor is transparency. Reports coming directly from individual hedge fund managers are perceived to provide better insight than a fund of funds report that rolls up the results of multiple managers. Finally, there is the desire to keep fees to a minimum, and investing directly may circumvent fund of funds-level fees. That said, due diligence, manager monitoring and reporting along with other services provided by funds of funds managers are never free and must be absorbed by the client in a direct relationship. COMMITTING TO DIRECT INVESTING This gets to the point that there are definite considerations that an institution should weigh when making a commitment to direct investing. These include: Access The objective of sourcing unique talent among a vast and diverse universe of hedge fund managers raises the central question of access: Is the institution able to invest with top-tier hedge fund managers many of whom may be inaccessible to all but the largest institutional investors or merely settle for those that are available? Investment due diligence Vetting hedge fund managers is a time- and resource-intensive task. Proper diligence requires understanding the manager s investment profile in the context of style and strategy in comparison to peers, to the broad hedge manager universe and to long-only metrics. INSIGHTONLINE spring/2014 3

4 Operational complexity Hedge funds are not as straightforward as traditional asset classes. A few of the things investors need to do are establish custodial relationships, complete subscription documents and redemption forms, understand fair market valuation policies and factor delayed reporting of NAVs into their return calculations. Liquidity Investors should understand how liquid or illiquid a particular strategy is and the impact to the overall hedge portfolio. Less-liquid strategies, like credit and distressed debt, could provide greater complexity and alter the allocation decision, while long/ short equity or macro strategies are generally more liquid. Risk management The institution has to synthesize all of these factors and develop a risk management discipline that allows them to comfortably make an investment in selected hedge funds. Thus, while there are attractions associated with direct hedge fund investing, institutions should realistically assess the resources needed to construct and manage a well-diversified allocation via the direct route. Help is available, however, through consultants and third-party providers that have developed hedge fund advisory services. This means that, depending on their circumstances, institutions of all sizes may be able to pursue the direct option. THE ROLE OF FUNDS OF FUNDS The same can be said for funds of funds. They can be equally appropriate for institutions of all sizes and, of course, the institution is not absolved of robust due diligence it simply shifts to carefully researching the funds of funds under consideration. But, when an institution invests in a fund of funds, it is investing in a vehicle that is closer to a total portfolio management solution. The fund of funds manager has vetted the hedge fund managers, constructed the portfolio and monitors it through time. Depending on the nature of the fund of funds, it can also deliver the all-important benefit of diversification; there is no rule of thumb, but most funds of funds are constructed around funds (some could hold 50 or more names). Most funds of funds take a multi-strategy approach with a varying degree of market exposure. It is common to see these funds of funds diversified by strategy, style and region. In addition, there are also strategy-, region- and sector-focused funds of funds. An example is a multi-strategy fund focused on Asia or, somewhat less prevalent, a technology-focused fund of funds. Investors may want to remember that the decision is not binary. They have the option to include both direct investments and funds of funds in the same portfolio. An investor may employ a hedge fund of funds as its core allocation and complement it with a satellite strategy focused on a particular strategy or region. CONCLUSION Clearly, there are roles for thoughtfully constructed hedge fund allocations in long-term institutional portfolios. The question of how to implement via direct investment with hedge fund managers or funds of funds must be answered by each institution. As institutional experience with hedge fund strategies has deepened, many are choosing the direct alternative in order to fine-tune their allocation and respond to specific portfolio objectives. These investors shoulder the responsibility for essential functions that would otherwise be provided by funds of funds and, thus, should have adequate resources or turn to consultants or hedge fund advisory services for supplementary support. Whatever route is selected, the good news is that investors have three viable alternatives: direct, funds of funds or a hybrid combination of both. INSIGHTONLINE spring/2014 4

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